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Appendix. Summary Of Micro-States
I would like to thank Prasad Bhattacharya, Philippe Callier, Martin Cihak, Dale Gray, Kangi Kpodar, Pamela Madrid, Paul Mathieu, Carlos Medeiros, Camelia Minoiu, Mahvash Qureshi, Scott Roger, Heidi Ryoo, Issouf Samake, Kenneth Train and Romain Veyrune for useful comments. This paper was presented at the Australasian Macroeconomic Workshop held in Melbourne April 14–15, 2009. The usual disclaimer applies.
In this paper, except where explicitly mentioned, size of a country will refer to the size of the population, not to its geographical or economic size.
Some authors (e.g.,Armstrong et al., 1998) estimate that microstates are richer on average than other states, implying that small size is not a barrier to wealth. We consider this finding questionable. Many islands in the Caribbean and the Pacific ocean have attracted billionaires and rich retired people because of favorable tax policies and good weather. These outliers drive up income per capita: when Bill Gates enters a restaurant, the average person in that restaurant becomes a millionaire, and if the restaurant contains only a few people, even a billionaire.
Some of the islands are archipelagos, spread across hundreds of miles, particularly in the Pacific, and some are mountainous. Geography can raise transportation costs.
One public good that is often not supplied at all in microstates is defense, as we explain below.
The rule of law is more difficult to apply in microstates because representatives of the law—judges, police officers—interact continuously with guilty parties both before and after the law has been applied. In this environment, ‘retaliation,’ broadly defined, is more likely. For instance, a police officer who fines a restaurant owner for a traffic violation might not be well served in that establishment thereafter.
Microstates might not even be able to develop a critical mass in specialized industries, simply because of this labor constraint.
A related geographical problem is a lack of natural endowments in most microstates. A small population is with certain exceptions correlated with small geographical size. The local resource base of most microstates is often constrained by limited geographical area and natural endowments. Moreover, because most microstates do not produce manufactured goods or produce, ships enter the ports with full containers but leave with empty ones, which adds to transportation costs.
The introduction of CATS (catastrophic bonds) provided a financial product that can help insure against such problems, though the high cost means that it is only accessible for richer microstates.
Bolton and Roland (1997) make the case that “regions with very low income inequality may want to break away from a nation with high income inequality and high tax rates in order to impose lower tax rates, and vice versa a region with high income inequality may want to separate in order to impose more redistribution than in the unified country” (p. 1059).
Another argument for microstates is that there are diseconomies of scale in the provision of administrative goods. While this argument is true for large states, it is doubtful for microstates that are so small to begin with.
History is full of examples of microstates that achieved prosperity. The city-states of Italy, the Hanseatic Cities, and the Low Countries during the Renaissance are examples of microstates that prospered by taking advantage of free European trade. In this period city states did not provide many public goods, so there were no large economies of scale in provision of public goods, such as military technology, which at the time still had no large economies of scale (see Alesina and Spolaore, 2003).
It is not clear whether a microstate can really benefit from proactive macro policies. The history of floating exchange rates for most developing countries has been poor. Until the early 20th century most developing countries, at the time still colonies, did not have central banks but had either notes issued by private commercial banks, as in Latin America, or currency boards, as in most self-governing British colonies (Schuler, 1992). Most of the countries experienced rising inflation and limited currency convertibility after they created a domestic currency. With destabilizing currencies, they also became net exporters of capital, for instance through capital flight.
What type of monetary policy should a central bank with a floating exchange rate choose? Typically, the decision requires targeting the monetary base or inflation, which creates the problems of defining the target and controlling it. If the central bank targets money supply, what measures of money supply does it target? It must control the measure it has chosen, set a target, achieve it, and regularly revise the target to take account of structural changes (e.g., new technologies) that can make money supply unpredictable. Problems of defining and achieving targets led most central banks in developed countries to abandon money supply targets in the 1980s. As microstates become more sophisticated, they could in principle move to inflation targeting. However, the institutional preconditions are important: policy must be transparent, there must be regular communication with the public, forecast models and information on the monetary transmission mechanism must be good, etc. Also, monetary policy has long lags, and the central bank has to act preemptively to reduce inflation. In microstates, the importance of exchange rate fluctuations for monetary policy changes cannot be ignored due to the high pass-through. This suggests that an inflation targeting microstate would probably have to manage the exchange rate in some way.
It is not clear even theoretically whether an independent monetary policy is desirable. The monetarist school, for instance, emphasizes that long and variable lags mean that the impact of monetary policy on the economy is not necessarily predictable (Laidler, 1982). The rational expectation school has argued that because people can anticipate monetary policy, it can only be effective if it acts via surprises. The problem is that surprises will destabilize the economy, causing higher inflation than rule-based monetary policy (Barro and Gordon, 1983). In sum, procyclical capital flows tend to generate booms with low inflation, followed by recessions with inflationary pressures, reducing the room for monetary authorities to maneuver with truly countercyclical policies. So long as interest rates are procyclical, central banks have limited capacity to manage rates in a countercyclical fashion and may actually reinforce the procyclicality of capital flows and generate exchange rate volatility.
This can create exchange rate risks because exchange rates are sensitive to small inflows, since FX markets for currencies of microstates are lightly traded. For example, the FX market in the Seychelles rupee in early 2009 is about US$300,000 per day. This means that large FDI projects can lead to large swings of the FX market.
A further critique of floating exchange rate is that excessive exchange rate volatility cannot be fully explained by macroeconomic fundamentals, and that volatility has inhibited international trade (Flood and Rose, 1995, and Klein and Shambaugh, 2007). Also, foreign direct investment might suffer because investors prefer exchange rate certainty when investing in new facilities.
Another way of formulating this problem is that in microstates, the share of tradables in the Consumer Price Index is higher than in bigger countries. Moreover, the non-tradable sector is very small. Both of these imply that an independent monetary policy will place a high weight on the exchange rate, and independent monetary policy will therefore have limited advantage in providing macroeconomic stability over a hard peg.
Fiscal dominance is probably not as much of a problem in microstates as in other countries. Because financial markets in most microstates lack depth, they have limited capacity to absorb government debt even when forced to through moral suasion or by law. This makes it difficult to monetize debt, which is mostly in foreign currency.
Devaluation is probably not a flexible instrument. Used once, it could affect the expectations of economic agents in a way that makes it more difficult to use in the future. Moreover, in emerging markets in recent years devaluations have often been contractionary because of balance sheet effects.
Other factors, notably political considerations, also matter. Goodhart (1995) states that most countries are not OCAs even if they have recently created territorial currencies; he suggests that an OCA has “relatively little predictive power” (p.452) in explaining the creation of currencies.
Moreover, if a microstate is dollarized and has emigrants to the US, this creates more labor mobility and makes dollarization work better than say a country without this type of international labor mobility.
Note that the studies do not discuss whether dollarized economies have lower volatility or not; it could be the case that the welfare cost of slower growth could be offset by the welfare benefits from lower volatility, thereby reinforcing the case for dollarization.
The gold standard was a special case of a currency board where the value of the national currency was linked to the value of gold rather than a foreign currency. The idea of currency boards originated in Britain in the early 1800s among a group of economists known as the “Currency School” that had great political influence. The Bank Act of 1844 was intended to convert the Bank of England into a currency board. Unlike modern advocates of currency boards, though, the Currency School did not realize that both deposits and notes that comprise the monetary base has to be backed 100 percent with foreign assets in a currency board system. Because the Bank Act had no reserve requirement for deposits, instead of converting the Bank of England into a currency board, the act converted it into a central bank. Because Britain was the most economically advanced country of the time, its example was influential, and many other countries imitated the British legislation (see Helleiner, 2004).
Currency boards also existed in independent countries as diverse as Argentina in the early 1900s, the free city of Danzig in the 1920s, and Yemen, but most of the long-term successes have been in microstates (see Wolf et al., 2008).
Note that Table 3 includes countries that at one time had pegged exchange rates, such as Mauritius or Seychelles, but that have in recent years moved towards more flexible exchange rate regimes.
In a CBA commercial banks hold no deposits at the currency boards. Reserve currency assets are the main form of commercial bank reserves.
In microstates bank runs reflect less a fear of the bank going bust than depositors taking their money out to convert it into a foreign currency. In other words, bank runs are a reflection of poor macroeconomic policy, not fear of banks going under. A CBA reduces this fear considerably.
We also tested separately for the probability of how size of the economy as measured by GDP affects the exchange rate choice. We found that it is negatively correlated with dollarization and positively correlated with CBAs. Here we clearly encounter a problem of endogeneity that we cannot correct for directly. When we used as an instrumental variable lagged income per capita and GDP, the results did not change significantly. If, as it appears, among microstates the size of the economy is negatively related to the hardness of the peg, this could relate to our hypothesis that dollarization requires the least upfront cost, CBA requires some spending, and fixed pegs require much more.